UK Eases, Greek and French Elections, US Data

The US dollar somewhat firmer in a relatively subdued foreign exchange market as last minute position adjustments are made in waning hours ahead of what many expect to be a key weekend with Greek and French elections. Greek exit polls are expected to begin around midday (ET) with official results out prior to the opening of the Asian session Monday. The threat of coordinated central bank action has rekindled ideas of potential BOJ intervention and this seems to largely account for the yen's strength today, following the BOJ's decision to keep policy on hold, but upgrade the economic assessment. Global equity markets are mostly higher, with the MSCI Asia Pacific gaining almost 1%, for highest close since mid-May, while the EuroStoxx 600 is up about 0.8%, led by a nearly 2% gain in financials near midday in London. The US reports industrial production and there is some risk that manufacturing contracted. The Empire State survey may attract some interest as it is the first report for June. However, the market's ability to forecast it is poor and the consensus has badly missed the past two months. The April TIC data will also be released but does not typically elicit a market response. France also holds the final round of parliamentary elections, but it is now widely expected that Hollande will have center-left majority in the lower house as he does in the upper house. This, we suggest, marks both a victory for Hollande but also the end of his honeymoon. A budget will soon be presented and additional austerity is needed if France is going to meet its fiscal targets. In addition, there are other domestic issues pending that appear to have been put off until after the election, like 3CIF (Caisse Centrale du Credit Immobilier de France). With the election behind him, Hollande is also in better position to find compromises with Germany. Yet it is the Greek election that is capturing the imagination of millions. The conventional view seems to be that the European officials will respond to a Syriza victory by forcing Greece out of EMU most likely through the ECB refusing to lend to Greek banks and denying it access to Target 2 payment/settlement system. We are not as sanguine. We expect that regardless of the electoral outcome a new phase of negotiations will begin. However, we recognize as the worst outcome, scenario that few seem to be truly considering, but one we suspect has a reasonable chance of materializing and that is another indecisive result where no majority can be cobbled together. Past the elections, the market will quickly turn its attention to the two-day FOMC meeting. The string of poor data, especially since the June 1 employment report has increased the likelihood of a policy response. Disappointment with the Empire survey today or a contraction in manufacturing output (which would be the second in three months) can only fan such expectations. We are more inclined to see officials use its statement and forecasts to guide market expectations and see a greater chance of a new Operation Twist (perhaps selling slightly longer dated maturities--like 4 years and buying long-dated MBS) than increasing the size of the balance sheet (QE). The UK signaled it new unorthodox policy measures a week after the central bank failed to act at the policy making meeting. Two main measures were announced, while BOE Governor King seemed to hint at additional action next month by observing that the case for additional easing continues to grow. This would likely entail new gilt purchases. Since introducing QE, the BOE has purchases GBP325 bln of gilts. First, the Bank of England will inject at least GBP5 bln a month in a reactivated Extended Collateral Term Repo (6-month liquidity facility). Second, he BOE will reduce funding costs for banks on loans to businesses and households through a swap facility backstopped by the Her Majesty's Treasury. Initial projections estimate the two measures to be worth between GBP80-GBP100 bln. To be successful it must spur an increase in lending, otherwise it is just widening the profit-margin on normal lending. This assumes that the problem is on the supply of credit. Yet there good reasons, such as the already very low interest rates and stronger corporate balance sheets, to suspect the more acute problem may be on the demand. The clearest market response has been on the short-end of the UK yield curve. The implied yield of the Dec short-sterling futures contract is off about 15 bp today and about 25 bp since mid-week. Neither the long end of the curve nor sterling itself appears to have been impact by the easing of policy and the signal that a new round of gilt purchases is likely as early as next month.